You have just graduated from the MBA program of a large university, and one of your favorite courses

was Todays Entrepreneurs. In fact, you enjoyed it so much you have decided you want to be your own boss. While you were in the masters program, your grandfather died and left you $1 million to do with as you please. You are not an inventor, and you do not have a trade skill that you can market; however, you have decided that you would like to purchase at least one established franchise in the fast-foods area, maybe two (if profitable). The problem is that you have never been one to stay with any project for too long, so you figure that your time frame is 3 years. After 3 years you will go on to something else. You have narrowed your selection down to two choices: (1) Franchise L, Lisas Soups, Salads, & Stuff, and (2) Franchise S, Sams Wonderful Fried Chicken. The net cash flows shown below include the price you would receive for selling the franchise in Year 3 and the forecast of how each franchise will do over the 3-year period. Franchise Ls cash flows will start off slowly but will increase rather quickly as people become more health conscious, while Franchise Ss cash flows will start off high but will trail off as other chicken competitors enter the marketplace and as people become more health conscious and avoid fried foods. Franchise L serves breakfast and lunch, while Franchise S serves only dinner, so it is possible for you to invest in both franchises. You see these franchises as perfect complements to one another: You could attract both the lunch and dinner crowds and the health conscious and not so health conscious crowds without the franchises directly competing against one another. Here are the net cash flows (in thousands of dollars):
EXPECTED NET CASH FLOW Year 0 1 2 3 Franchise L ($100) 10 60 80 Franchise S ($100) 70 50 20

Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows. You also have made subjective risk assessments of each franchise, and concluded that both franchises have risk characteristics that require a return of 10 percent. You must now determine whether one or both of the franchises should be accepted. a. What is capital budgeting? b. What is the difference between independent and mutually exclusive projects? c. (1) What is the payback period? Find the paybacks for Franchises L and S. (2) What is the rationale for the payback method? According to the payback criterion, which franchise or franchises should be accepted if the firms maximum acceptable payback is 2 years, and if Franchises L and S are independent? If they are mutually exclusive? (3) What is the difference between the regular and discounted payback periods? (4) What is the main disadvantage of discounted payback? Is the payback method of any real usefulness in capital budgeting decisions? d. (1) Define the term net present value (NPV). What is each franchises NPV? (2) What is the rationale behind the NPV method? According to NPV, which franchise or franchises should be accepted if they are independent? Mutually exclusive? (3) Would the NPVs change if the cost of capital changed? e. (1) Define the term internal rate of return (IRR). What is each franchises IRR? (2) How is the IRR on a project related to the YTM on a bond? (3) What is the logic behind the IRR method? According to IRR, which franchises should be accepted if they are independent? Mutually exclusive? (4) Would the franchises IRRs change if the cost of capital changed? f. (1) Draw NPV profiles for Franchises L and S. At what discount rate do the profiles cross?

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(2) Look at your NPV profile graph without referring to the actual NPVs and IRRs. Which franchise or franchises should be accepted if they are independent? Mutually exclusive? Explain. Are your answers correct at any cost of capital less than 23.6 percent? g. (1) What is the underlying cause of ranking conflicts between NPV and IRR? (2) What is the reinvestment rate assumption, and how does it affect the NPV versus IRR conflict? (3) Which method is the best? Why? h. (1) Define the term modified IRR (MIRR). Find the MIRRs for Franchises L and S. (2) What are the MIRRs advantages and disadvantages vis--vis the regular IRR? What are the MIRRs advantages and disadvantages vis--vis the NPV? i. As a separate project (Project P), you are considering sponsoring a pavilion at the upcoming Worlds Fair. The pavilion would cost $800,000, and it is expected to result in $5 million of incremental cash inflows during its 1 year of operation. However, it would then take another year, and $5 million of costs, to demolish the site and return it to its original condition. Thus, Project Ps expected net cash flows look like this (in millions of dollars):
Year 0 1 2 Net Cash Flows ($0.8) 5.0 (5.0)

EXPECTED NET CASH FLOW Year 0 1 2 3 4 Project S ($100,000) 60,000 60,000 Project L ($100,000) 33,500 33,500 33,500 33,500

l.

The projects provide a necessary service, so whichever one is selected is expected to be repeated into the foreseeable future. Both projects have a 10 percent cost of capital. (1) What is each projects initial NPV without replication? (2) Now apply the replacement chain approach to determine the projects extended NPVs. Which project should be chosen? (3) Now assume that the cost to replicate Project S in 2 years will increase to $105,000 because of inflationary pressures. How should the analysis be handled now, and which project should be chosen? You are also considering another project that has a physical life of 3 years; that is, the machinery will be totally worn out after 3 years. However, if the project were terminated prior to the end of 3 years, the machinery would have a positive salvage value. Here are the projects estimated cash flows:
Initial Investment and Operating Cash Flows ($5,000) 2,100 2,000 1,750 End-of-Year Net Salvage Value $5,000 3,100 2,000 0

The project is estimated to be of average risk, so its cost of capital is 10 percent. (1) What are normal and nonnormal cash flows? (2) What is Project Ps NPV? What is its IRR? Its MIRR? (3) Draw Project Ps NPV profile. Does Project P have normal or nonnormal cash flows? Should this project be accepted? j. What does the profitability index (PI) measure? What are the PIs of Franchises S and L? k. In an unrelated analysis, you have the opportunity to choose between the following two mutually exclusive projects:

Year 0 1 2 3

Using the 10 percent cost of capital, what is the projects NPV if it is operated for the full 3 years? Would the NPV change if the company planned to terminate the project at the end of Year 2? At the end of Year 1? What is the projects optimal (economic) life? m. After examining all the potential projects, you discover that there are many more projects this year with positive NPVs than in a normal year. What two problems might this extra large capital budget cause?

Chapter 12

Capital Budgeting: Decision Criteria 433

Shrieves Casting Company is considering adding a new line to its product mix, and the capital budgeting analysis is being conducted by Sidney Johnson, a recently graduated MBA. The production line would be set up in unused space in Shrievess main plant. The machinerys invoice price would be approximately $200,000, another $10,000 in shipping charges would be required, and it would cost an additional $30,000 to install the equipment. The machinery has an economic life of 4 years, and Shrieves has obtained a special tax ruling that places the equipment in the MACRS 3-year class. The machinery is expected to have a salvage value of $25,000 after 4 years of use. The new line would generate incremental sales of 1,250 units per year for 4 years at an incremental cost of $100 per unit in the first year, excluding depreciation. Each unit can be sold for $200 in the first year. The sales price and cost are both expected to increase by 3 percent per year due to inflation. Further, to handle the new line, the firms net operating working capital would have to increase by an amount equal to 12 percent of sales revenues. The firms tax rate is 40 percent, and its overall weighted average cost of capital is 10 percent. a. Define incremental cash flow. (1) Should you subtract interest expense or dividends when calculating project cash flow? (2) Suppose the firm had spent $100,000 last year to rehabilitate the production line site. Should this be included in the analysis? Explain. (3) Now assume that the plant space could be leased out to another firm at $25,000 per year. Should this be included in the analysis? If so, how? (4) Finally, assume that the new product line is expected to decrease sales of the firms other lines by $50,000 per year. Should this be considered in the analysis? If so, how? b. Disregard the assumptions in part a. What is Shrievess depreciable basis? What are the annual depreciation expenses? c. Calculate the annual sales revenues and costs (other than depreciation). Why is it important to include inflation when estimating cash flows?

d. Construct annual incremental operating cash flow statements. e. Estimate the required net operating working capital for each year and the cash flow due to investments in net operating working capital. f. Calculate the after-tax salvage cash flow. g. Calculate the net cash flows for each year. Based on these cash flows, what are the projects NPV, IRR, MIRR, and payback? Do these indicators suggest that the project should be undertaken? h. What does the term risk mean in the context of capital budgeting; to what extent can risk be quantified; and when risk is quantified, is the quantification based primarily on statistical analysis of historical data or on subjective, judgmental estimates? i. (1) What are the three types of risk that are relevant in capital budgeting? (2) How is each of these risk types measured, and how do they relate to one another? (3) How is each type of risk used in the capital budgeting process? j. (1) What is sensitivity analysis? (2) Perform a sensitivity analysis on the unit sales, salvage value, and cost of capital for the project. Assume that each of these variables can vary from its base-case, or expected, value by 10, 20, and 30 percent. Include a sensitivity diagram, and discuss the results. (3) What is the primary weakness of sensitivity analysis? What is its primary usefulness? k. Assume that Sidney Johnson is confident of her estimates of all the variables that affect the projects cash flows except unit sales and sales price. If product acceptance is poor, unit sales would be only 900 units a year and the unit price would only be $160; a strong consumer response would produce sales of 1,600 units and a unit price of $240. Johnson believes that there is a 25 percent chance of poor acceptance, a 25 percent chance of excellent acceptance, and a 50 percent chance of average acceptance (the base case). (1) What is scenario analysis? (2) What is the worst-case NPV? The best-case NPV?
Capital Budgeting: Estimating Cash Flows and Analyzing Risk 477

Chapter 13

(3) Use the worst-, most likely, and best-case NPVs and probabilities of occurrence to find the projects expected NPV, standard deviation, and coefficient of variation. l. Are there problems with scenario analysis? Define simulation analysis, and discuss its principal advantages and disadvantages. m. (1) Assume that Shrievess average project has a coefficient of variation in the range of 0.2 to 0.4. Would the new line be classified as high

risk, average risk, or low risk? What type of risk is being measured here? (2) Shrieves typically adds or subtracts 3 percentage points to the overall cost of capital to adjust for risk. Should the new line be accepted? (3) Are there any subjective risk factors that should be considered before the final decision is made? n. What is a real option? What are some types of real options?

SELECTED ADDITIONAL REFERENCES AND CASES

A paper on the effect of inflation on capital budgeting is Mehta, Dileep R., Michael D. Curley, and Hung-Gay Fung, Inflation, Cost of Capital, and Capital Budgeting Procedures, Financial Management, Winter 1984, pp. 4854. The following articles pertain to other topics in this chapter: Kroll, Yoram, On the Differences between Accrual Accounting Figures and Cash Flows: The Case of Working Capital, Financial Management, Spring 1985, pp. 7582. Mukherjee, Tarun K., Reducing the UncertaintyInduced Bias in Capital Budgeting DecisionsA Hurdle Rate Approach, Journal of Business Finance & Accounting, September 1991, pp. 747753. The literature on risk analysis in capital budgeting is vast; here is a small but useful selection of additional references that bear directly on the topics covered in this chapter: Butler, J. S., and Barry Schachter, The Investment Decision: Estimation Risk and Risk Adjusted Discount Rates, Financial Management, Winter 1989, pp. 1322. Weaver, Samuel C., Peter J. Clemmens III, Jack A. Gunn, and Bruce D. Danneburg, Divisional Hurdle Rates and the Cost of Capital, Financial Management, Spring 1989, pp. 1825. The following cases from Textchoice, Thomson Learnings online library, cover many of the concepts discussed in this chapter and are available at http://www.textchoice2.com. Klein-Brigham Series: Case 12, Indian River Citrus Company (A), Case 12A, Cranfield, Inc. (A), and Case 14, Robert Montoya, Inc., focus on cash flow estimation. Case 13, Indian River Citrus (B), Case 13A, Cranfield, Inc. (B), Case 13B, Tasty Foods (B), Case 13C, Heavenly Foods, and Case 15, Robert Montoya, Inc. (B), illustrate project risk analysis. Case 58, Universal Corporation, is a comprehensive case that illustrates Chapters 13 and 14, as do Cases 47 and 48, The Western Company (A and B). Brigham-Buzzard Series: Case 7, Powerline Network Corporation (Risk and Real Options in Capital Budgeting).

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